Since the financial crisis, changing regulation and a more conservative risk environment mean that banks have been reluctant to make loans of the size that they did prior to the crash in 2008. As a result, small and medium-sized companies have had to look to other financing providers. One, albeit small, source of funding has been institutional investors, which have established pure direct lending funds to service this growing demand.Patrick Marshall, Head of Private Debt & CLOs at Hermes Investment Management, discusses the options for loan origination.

Like all asset classes, this asset class comes with inherent risks. These include credit risk in the form of borrowers’ defaults, which was a significant issue for lenders during the financial crisis. Medium-sized companies have an average default rate of around 3.1% over the past 10 years. However, senior secured loans, which stand at the top of the capital structure, enjoy average recoveries on default in Europe in excess of 75%, which is significantly higher than some other asset classes such as high yield bonds.

A more pressing issue for investors today is the significant uptick in capital allocated to private debt funds. The amount of dry powder yet to be deployed in private debt in Europe is at an all-time high. This combination of needing to minimise credit risk and competition for opportunities means that loan selection and origination are more important than ever for private debt investors.

The first solution to these challenges is to conduct detailed analysis of each opportunity, undertaking full financial and business analysis to ascertain the risk of a credit event with the borrower. The analysis is undertaken from a top-down and bottom-up perspective. Top-down research sheds light on broader industry dynamics, such as sensitivity to the business cycle, the level of competition in a sector and pertinent regulatory issues. However, it is also vital to understand the business’s own model, the resilience of this and its financial profile. Further considerations are the borrower’s ownership structure and management team as both these constituents will be paramount to the success of a business. An ability to negotiate the right terms within the loan documentation is important in providing the lender with the right level of safeguards for the life of the loan. This can only be undertaken by a highly experienced team.

The other half of the solution is having access to the best deals in the first place. The ability for the loan provider to be able to choose the right loans protects them from becoming a forced lender, who is obliged to deploy in the very few opportunities that arise. In order to maximise the loan opportunities available, Hermes signed an exclusive co-lending partnership with RBS. This agreement is a real differentiator from any other in the market, and a game changer for the fund as RBS is required to share all lending opportunities, within certain parameters, with us. This allows us to choose whether or not to progress an opportunity, and ensures that investors can consider a broad and consistent range of deals with limited direct competition from other private debt funds. RBS was the second-largest middle-market lender in the UK in 2015 and 2016, which reflects the volume of deals available through this kind of partnership.

An experienced team will also be able to access compelling loan opportunities in the market through contacts working in the corporate world, financial advisors such as audit firms and law firms, among others. While this deal flow is not as consistent as that offered by a partnership, it provides some idiosyncratic opportunities that may not come to the attention of larger lenders. By combining original partnerships with deals sourced through existing contacts, investors should still be able to select the best loan opportunities in an increasingly competitive market.

In a world of low return, direct lending offers a compelling opportunity for investors in terms of risk-reward. While loan investments have their risks, by carefully selecting borrowers from a range of deal sources, investors can lend to sustainable, reliable businesses and achieve a significant potential rate of return in the process.